Recent legislation, along with developments from the Organisation for Economic Cooperation and Development (OECD) has put a renewed emphasis on intangible property in a transfer pricing context. In this article, we will discuss some of the critical issues pertaining to intangibles in a transfer pricing situation that companies should be mindful of in their tax planning.
Intangible Property Transfers
Common intercompany IP transfer methods are as follows:
- Outright transfer, either by sale or through a nonrecognition transfer
- Royalty-bearing license
- Provision of a service using the intangible property, rather than a direct transfer of the property
- Cost-sharing arrangement (CSA)
A CSA is a contractual agreement between companies in the same multinational group which allows the companies to share the costs and risks of developing, producing, or obtaining assets. In a CSA, companies decide to share the development of a global IP platform, for example, R&D. An often contentious issue is determining the buy-in, or platform contribution transaction (PCT) that each party has contributed.
In 2013, new cost-sharing regulations became effective amid controversy surrounding the application of methods used in high profile court cases. As a result of U.S. companies abusing cost-sharing regimes, cost-sharing participants are no longer able to only contribute cash to a CSA. IRC Sec. 482-7 outlines methods in connection with IP transactions in the context of cost-sharing arrangements (CSAs). The new regulations formalize the use of the Income Method for determining the value of the IP. Previous requirements called for use of a valuation approach but didn’t identify a specific method.
Transfer Pricing vs. PPA
The new cost-sharing regulations highlight differences between the application of the income method for transfer pricing purposes versus financial reporting purposes. In a purchase price allocation, there is a delineation between intangibles and goodwill. For transfer pricing purposes, the distinction between intangibles and goodwill is blurred. The valuation involves consideration of not only what the value is today but also what the value will be post-acquisition. For example, what will the value of the intangible be once the buyer has integrated it into its distribution channels or its product line? In a transfer pricing situation, the value of the intangibles might include all of goodwill.
The IRS has referenced in recently published papers the distinction between valuations for financial reporting purposes and valuations for transfer pricing purposes, specifically stating that valuations for allocation of purchase price should only be used as a “starting point” for transfer pricing purposes.
The following are other key considerations with respect to valuations for transfer pricing purposes:
- Differences in definitions of IP and goodwill. The IRS has the perspective that some of goodwill should be included as part of intangibles. If U.S.-based IP is going to be transferred out of the United States, the IRS wants to ensure that the value placed on that IP is as high as possible.
- Discount rates. The IRS states that discount rates associated with certain IP transactions should be higher than the overall discount rate from the weighted average cost of capital (WACC).
- Technology. The IRS views technology, such as software, as something that never fully amortizes. Thus, the income stream would go out further, impacting the valuation.
Base Erosion and Profit Shifting (“BEPS”) Action Plan
The OECD is moving in a direction similar to the U.S. in tightening controls and making sure that OECD member countries do not assign a low value to IP for purposes of transferring it out of one jurisdiction into a more favorable tax jurisdiction. In recent years, the OECD has expressed concern over practices that artificially segregate taxable income from the activities that generate it. The OECD’s position is that profits should be going to the place where the profit is being generated.
To ensure that OECD member countries are not subject to “unfair base erosion practices and profit shifting,” the OECD developed the Base-Erosion and Profit Shifting (BEPS) Action Plan in 2013. With respect to transfer pricing, the OECD’s main objective is to “assure that transfer pricing outcomes are in line with value creation.” In its action plan, the OECD details the following goals:
- Adopt a broad and clearly delineated definition of intangibles.
- Ensure that profits associated with the transfer and use of intangibles are appropriately allocated in accordance with (rather than divorced from) value creation.
- Develop transfer pricing rules or special measures for transfers of hard-to-value intangibles
- Update the guidance on cost contribution arrangements.
- Adopt transfer pricing rules or special measures to ensure inappropriate returns will not accrue to an entity solely because it contractually assumed risks or provided capital.
To avoid scrutiny from the IRS it is important to obtain a supportable valuation of IP. If you do not have a defensible IP structure in place, tax authorities will assert their view.